bowlin et al - 2014 - the effects of auditor rotation, professional skepticism, and interactions with managers on audit quality

The Effects of Auditor Rotation, Professional Skepticism, and Interactions with Managers on Audit Quality Kendall O Bowlin Assistant Professor, University of Mississippi, kobowlin@olemiss.edu Jessen L Hobson Assistant Professor, University of Illinois at Urbana-Champaign, JLhobson@illinois.edu M David Piercey Associate Professor, University of Massachusetts Amherst, piercey@isenberg.umass.edu July 2014 We thank Don Moser (editor), two anonymous reviewers, Chris Agoglia, Michael Bamber, Charles Bailey, Tim Bauer, Bryan Church, Vicki Dickinson, Kirsten Fanning, Bracken Hodges, Joseph Johnson, Bin Ke, Tom Kida, Tamara Lambert, Clive Lennox, Tracie Majors, Bill Messier, Mark Peecher, Steve Perreault, Aaron Saiewitz, Lori Shefchik, Roger Silvers, Chad Simon, Steve Smith, John Spraggon, Matthew Stern, Hun-Tong Tan, Bill Tayler, Todd Thornock, Kristy Towry, Elaine Wang, Karl Wang, Carolyn Westfall,  Aaron Zimbelman, conference participants at the American Accounting Association Annual and Audit Midyear Meetings, the Brigham Young University Accounting Research Symposium, and the MidSouth Accounting Research Consortium, as well as workshop participants at Georgia Institute of Technology, Nanyang Technological University, North Carolina State University, and the University of Massachusetts for their helpful comments We are also grateful to the University of Illinois at UrbanaChampaign, the University of Massachusetts Amherst, and the University of Mississippi for funding this research   The Effects of Auditor Rotation, Professional Skepticism, and Interactions with Managers on Audit Quality ABSTRACT We examine whether the effect of mandatory auditor rotation on audit quality depends on the mental frame auditors adopt in evaluating management representations In practice, auditors can alternately frame their assessments of management representations in terms of their potential dishonesty (what we term skepticism) or potential honesty Using psychology theory and a laboratory experiment, we predict and find that mandatory rotation improves audit quality when an auditor takes an honesty frame, but that this effect reverses when an auditor takes a skeptical frame Thus, the benefit of using a skeptical frame occurs when auditors not rotate, and requiring rotation can lead to inappropriately low audit effort for auditors using a skeptical frame An implication of our study is that focusing auditors on a skeptical assessment frame without requiring rotation may be a less costly way to reduce low-effort audits and aggressive reporting Key Words: Auditor Rotation; Professional Skepticism; Audit Quality; Game Theory   I INTRODUCTION We test whether the effects of auditor rotation on audit quality depend upon the mental frame (Hanson 2011) with which auditors evaluate either the honesty or dishonesty of management representations about the financial statements In particular, we explore whether auditor rotation and assessment frame interact, leading to low-effort audit and aggressive reporting In recent years, standard setters have proposed and implemented various forms of mandatory auditor rotation For example, the SEC requires rotation of audit engagement and concurring review partners (SEC 2003), and the European Union (EU) directs that key audit partners rotate (Commission of the European Communities 2006) Recently, both the U.S and Europe have revisited the recurring, controversial topic of audit firm rotation, with the EU, but not the U.S., moving forward with adoption of firm rotation While opponents suggest that the loss of experience with the audit client due to rotation reduces audit quality (e.g., Myers, Myers, and Omer 2003; PwC 2011; AICPA 2011b), the PCAOB and other proponents argue that existing rotation requirements in the U.S are insufficient and that firm rotation requirements will enhance audit quality and professional skepticism (e.g., PCAOB 2011a; PCAOB 2011b, footnote 2; Hall 2011) Proponents of auditor rotation may not take into account that the auditor’s frame when assessing management representations can vary among auditors, audit teams, audit firms, audits, and parts of audits (e.g., COSO 1992; Peecher 1996; AICPA 2007; Peecher, Piercey, Rich, and Tubbs 2010) Auditors can frame their assessments in terms of managers’ potential honesty (e.g., client integrity assessments, COSO 1992; AICPA 2007; PCAOB 2007), or potential dishonesty   (e.g., fraud risk assessments, AICPA 2011a) Psychology theory suggests that the auditor’s frame could interact with auditor rotation While auditing standards traditionally described professional skepticism as an attitude that includes an unbiased questioning mind (AICPA 2011c), regulators increasingly (though not uniformly) advocate for and characterize skepticism from a presumptive doubt perspective, in which auditors generally focus on the possibility of management dishonesty (Panel on Audit Effectiveness, PAE, 2008; PCAOB 2008; Nelson 2009; PCAOB 2011b; Doty 2012) This is a perspective observed in audit practice (Quadackers, Groot, and Wright 2014) Thus, we use the term “skeptical” to describe cases in which auditors assess management representations in terms of their potential dishonesty (see Nelson 2009, 4).1 We contribute to the literature by directly examining the interactive effects of auditor assessment frame and auditor rotation on audit quality Consistent with psychology theory, we predict that when auditors assess the honesty of management representations, auditor rotation will increase audit effort and decrease the frequency of low-effort audits paired with aggressive financial reporting On the other hand, when auditors assess the dishonesty (i.e., exercise skepticism) of management representations, auditor rotation likely strengthens the auditor’s belief that management representations are honest, thereby reducing audit quality Building upon and extending theories from psychology and economics, and drawing on prior research in accounting (King 2002; Bowlin, Hales, Kachelmeier 2009), we use an experiment to examine the effects of auditor rotation and assessment frame in a game theoretic, strategic setting (e.g., Fellingham and Newman 1985; Newman, Patterson and Smith 2005) Our experiment follows the principles of experimental economics (e.g., Davis and Holt 1993; Freidman and Sunder 1994; Kagel and Roth 1995; Smith 2003), which is an ideal method to                                                              Accordingly, we use the phrases skeptical frame and dishonesty frame interchangeably   examine auditor rotation, because participants assuming the role of auditors and managers can interact repeatedly in a real microeconomic world that captures the key economic and strategic forces at play in the natural setting (Plott 1982, 1492; Smith 1982, 923) This approach maximizes validity while controlling for confounding and nonessential factors by using random assignment, inexperienced subjects, and non-contextually rich language.2 We then rely on economic and psychology theory to generalize the results of our experiment to the natural setting In our experiment, a participant in the manager role chooses a level of financial reporting aggressiveness and makes a representation about that choice to a participant in the auditor role The auditor assesses the honesty or dishonesty of the management assertion and chooses a level of audit effort Consistent with prior auditing studies adopting similar methods, our design includes an incentive structure intended to parallel those encountered in real-world auditing interactions (e.g King 2002; Fischbacher and Stefani 2007; Bowlin et al 2009; and Bowlin 2011) For example, auditors prefer low-effort and low-cost audits, but only if managers are unlikely to choose aggressive financial reporting On the other hand, managers prefer aggressive reporting when auditors conduct low-effort audits, but prefer conservative reporting when auditors are more diligent We manipulate three variables between subjects First, we manipulate auditor rotation by requiring auditors to interact with the same or a different manager each round We manipulate auditor assessment frame by having auditors assess the veracity of management representations as either the probability that managers are honest or the probability that managers are dishonest                                                              As with all experiments, to the extent that our setting does not incorporate some aspects of the natural environment, future research can expand on our contribution by considering how these other factors might interact with our findings outside of our theory to alter our results (Friedman and Sunder 1994, 16; Kachelmeier and King 2002; Libby, Bloomfield, and Nelson 2002, 795; Smith 1982, 937).    Finally, as a robustness test, we manipulate whether auditors and managers are allowed to engage in interpersonal interaction by allowing half of the auditor-manager pairs to chat via text messages in an informal, yet controlled, environment Consistent with our predictions, we find that the effect of auditor rotation on audit quality depends on auditors’ assessment frame Specifically, when auditors assess the honesty of management representations (i.e., a client integrity frame), auditor rotation increases audit effort and decreases the frequency of low-effort audits paired with aggressive financial reporting, a pairing that increases the likelihood of audit failure (Peecher and Piercey 2008) However, when auditors assess the dishonesty of management representations (i.e., a skepticism frame), auditor rotation decreases audit effort and increases low-effort audits paired with aggressive reporting Additional analysis demonstrates that auditors’ assessment of management representations mediates audit effort, and ultimately the joint outcome of audit effort and aggressive reporting These findings recommend caution to those who advocate for the skeptical, presumptive doubt auditor assessment frame (Nelson 2009; Quadackers et al 2014), since our findings imply that audit situations requiring the auditor to assume management is dishonest, such as fraud risk assessments, would actually lead to increased audit failure under a mandatory auditor rotation scheme We also find that increasing the level of interpersonal interaction between auditors and managers via informal chatting decreases audit effort but does not interact with our other independent variables This suggests that our main findings could generalize to auditors who have close interactions with managers (e.g., engagement partners), as well as those who not (e.g., concurring partners and other audit team members)   Our findings have implications for theory and practice By examining the joint effects of assessment frame and rotation, we provide evidence that the effects of auditor rotation on audit quality can depend on whether auditors assess management assertions through an honesty or skeptical frame This suggests that the expected benefits of auditor rotation mandates could come at the cost of undoing expected benefits of professional skepticism standards Similarly, auditors should be aware of how these factors influence their judgment and decision-making (see Bell, Peecher, and Solomon 2005) For example, newly rotated auditors should be extra vigilant in fraud planning and procedures, perhaps focusing on best practices of high-quality fraud brainstorming (e.g., Brazel, Carpenter, and Jenkins 2010), and on falsifying (rather than verifying) management assertions during the audit (PAE 2008; Doty 2012) These findings extend prior experimental and archival literature on auditor rotation and skepticism We contribute to the experimental literature on rotation by focusing on unintentional under-auditing and auditors’ assessments of management representations and choices of audit effort levels that occur prior to auditors’ reporting decisions (Dopuch, King, and Schwartz 2001) We use an experiment to eliminate self-selection bias inherent in archival research on audit rotation Finally, we show that the presumptive doubt perspective of auditor skepticism found to be prevalent in prior research (Quadackers et al 2014) is potentially harmful when auditors rotate II THEORY Background Research Over the past decade, a large archival literature has studied auditor rotation, primarily by testing whether proxies for earnings quality or audit quality improve or deteriorate with longterm auditor-client relationships Reviews of this literature (e.g., Cameran, Prencipe, and   Trombetta 2008) describe mixed results.3 Myers et al (2003), Cameran et al (2008) and the PCAOB (2011b) note that self-selection bias limits the extent to which archival findings can address the effects of auditor rotation on audit quality Using an experiment, Dopuch, King, and Schwartz (2001, 98) find that rotation discourages auditors from intentionally biasing their audit opinions in favor of management, despite incentives to compromise their independence Wang and Tuttle (2009) examine the effect of rotation on auditor-manager negotiations These studies call for future research to examine other aspects of auditor rotation The Auditor-Manager Relationship We examine the auditor-manager relationship as a strategic game between individuals, consistent with prior experimental and analytical research (e.g., Fellingham and Newman 1985; Kachelmeier 1991; Newman, Rhoades, and Smith 1996; King 2002; Mayhew and Pike 2004; Bowlin et al 2009; Bowlin 2011) This relationship includes a key tension that mandatory rotation would presumably help alleviate: managers can benefit from aggressive financial reporting, but only if they can convince auditors to engage in low audit effort, while auditors can benefit from low audit effort, but only if managers engage in conservative financial reporting (e.g., King 2002; Bowlin et al 2009) Auditors plan their costly effort based, in part, on management representations about financial reporting quality, such as misstatement risk in an account or explanations for unusual fluctuations observed during analytical review (Aghazadeh 2013) However, management representations are not necessarily honest (Dichev, Graham, Harvey, and Rajgopal 2013) Auditors can assess the honesty or dishonesty of management representations, but the audit                                                              For example, Myers et al (2003), Mansi et al (2004), Ghosh and Moon (2005), Chen, Lin, and Lin (2008), Gul et al (2009), and Rice and Weber (2012) find negative effects of rotation on audit quality Carey and Simnett (2006), Kealy, Yee, and Stein (2007), Dao, Mishra, and Raghunandan (2008), and Davis, Soo, and Trompeter (2009) find positive effects Ghosh and Moon (2005), Knechel and Vanstraelen (2007), Chen et al (2008), Chi, Huang, Liao, and Xie (2009), and Ruiz-Barbadillo, Gomez-Aguilar, and Carrera (2009) find no or mixed effects   environment provides auditors imperfect feedback about whether those assessments are accurate (King 2002) For example, auditors know when they have detected misstatements, but they generally not know (and may never know) the private financial reporting decisions of their clients or whether there were undetected material misstatements (Peecher and Piercey 2008) Auditors’ Assessments of Management Representations Auditors can frame their assessments of management representations in terms of either their potential honesty or their potential dishonesty (Quadackers et al 2014) These alternative frames may arise formally (e.g., COSO 1992; AICPA 2011a) or informally on different audit tasks.4 Standard setters have recently noted that auditors often focus on verifying the honesty of management representations, and have encouraged auditors instead to evaluate them more skeptically in terms of their potential dishonesty (e.g., AICPA 2011a; PCAOB 2011b; and Doty 2012) According to Support Theory in psychology (Tversky and Koehler 1994; Rottenstreich and Tversky 1997; and Brenner, Koehler, and Rottenstreich 2002; Brenner 2003), individuals not make subjective probability assessments based on normative laws of probability, but instead base those assessments on the amount of subjective psychological support that comes to mind The Support Theory literature also finds that the ease with which such support comes to mind depends on how the probability assessment is framed For example, individuals asked to assess the likelihood that they will be injured within the next year can easily conjure mental support for this risk As a result, they evaluate the subjective likelihood of injury in their minds and not adequately consider the alternative complementary probability that they might not be injured In                                                               This is consistent with our conversations with partners and other auditors For example, audit teams will often refer to their knowledge of and experience with management’s integrity when deciding how much to rely on managers’ explanations for unexpected fluctuations observed in analytical review Auditors then may adopt a more skeptical mindset when participating in a fraud brainstorming session     contrast, asking individuals to assess the likelihood of an injury-free year leads them to overstate that possibility and inadequately consider the alternative, that they could be injured Thus, individuals’ subjective probability assessments of an uncertainty depend on how the question is framed Accordingly, researchers commonly gather evidence consistent with Support Theory by finding that the two, separately assessed complementary probabilities exceed 100% (see, e.g., Ayton 1997 and Brenner et al 2002 for reviews) In our setting, Support Theory predicts that auditors assessing the probability of the honesty (dishonesty) of management representations will focus on the possibility of honesty (dishonesty), and will conjure psychological support for it relatively easily Consequently, these auditors will assess honesty (dishonesty) to be more likely and will, therefore, select low-effort (high-effort) audits more frequently This is a mistake, because honesty and dishonesty assessments are two sides of the same coin (COSO 1992), and probability assessments of management honesty or dishonesty should be independent of the question’s mental framing Additionally, the features of a long-term auditor-client relationship further exacerbate such mistakes because extended, non-rotating experience with the client makes it even easier for auditors to conjure psychological support for their mental frame Thus, a traditional, non-rotating relationship would tend to magnify the tendency of auditors with an honesty frame to understate the likelihood that a particular representation might be true, while also magnifying the tendency of auditors with a skepticism frame to overstate the likelihood that a particular representation might not be true Mandatory Auditor Rotation and Honesty versus Dishonesty Assessments: A Reverse Effect We suggest that the effect of auditors adopting an honesty or dishonesty frame on their assessments of management representations depends on auditor rotation in ways that neither   MacKinnon, D P., G Warsi, and J H Dwyer 1995 A simulation study of mediated effect measures Multivariate Behavioral Research, 30 (1), 41-62 Erratum Multivariate Behavioral Research 30 (3): ii Mansi, S A., W F Maxwell, and D P Miller 2004 Does Auditor Quality and Tenure Matter to Investors? Evidence from the Bond Market Journal of Accounting Research 42 (4): 755793 Mayhew, B W., and J E Pike 2004 Does Investor Selection of Auditors Enhance Auditor Independence? The Accounting Review 74 (3): 797-822 McNeil, K., I Newman, and F J Kelley 1996 Testing Research Hypotheses with the General Linear Model Carbondale, IL: Southern Illinois University Press Messier, W., S Glover, and D Prawitt 2011 Auditing and Assurance Services: A Systematic Approach 8th ed McGraw-Hill: New York, NY Morgan-Lopez, A A., and MacKinnon, D P 2006 Demonstration and evaluation of a method for assessing mediated moderation Behavior Research Methods: 38 (1): 77-87 Myers, J N., L A Myers, and T C Omer 2003 Exploring the Term of the Auditor-Client Relationship and the Quality of Earnings: A Case for Mandatory Auditor Rotation? The Accounting Review 78 (3): 779-801 Nelson, M W 2009 A Model and Literature Review of Professional Skepticism in Auditing Auditing: A Journal of Practice & Theory 28 (2): 1-34 Newman, D P., and J Noel 1989 Error Rates, Detection Rates and Payoff Functions in Auditing Auditing: A Journal of Practice and Theory 8: 50 – 63 Newman, D P., E R Patterson, and J R Smith 2005 The Role of Auditing in Investor Protection The Accounting Review 80 (1): 289-313 Newman, D P., S Rhoades, and R Smith 1996 Allocating Audit Resources to Detect Fraud Review of Accounting Studies (2): 161-182 Ofir, C., and D Mazursky 1997 Does a Surprising Outcome Reinforce or Reverse the Hindsight Bias? Organizational Behavior and Human Decision Processes 69 (1): 51-57 PAE 2008 Panel on Audit Effectiveness: Public Oversight Board Report and Recommendations Stamford, CT: Public Oversight Board PCAOB 2007 Auditing Standard No 5: An Audit of Internal Control over Financial Reporting that is Integrated with an Audit of Financial Statements PCAOB Auditing Standards Washington, DC: Public Company Accounting Oversight Board PCAOB 2008 Report on the PCAOB’s 2004, 2005, 2006, and 2007 Inspections of Domestic Annually Inspected Firms PCAOB Release No 2008-008, Washington, DC: Public Company Accounting Oversight Board PCAOB 2009 Auditing Standard No 7: Engagement Quality Review PCAOB Auditing Standards Washington, DC: Public Company Accounting Oversight Board PCAOB 2011a PCAOB to Consider Concept Release on Auditor Independence and Audit Firm Rotation PCAOB Press Release Washington, DC: U.S Public Company Accounting, August 11 PCAOB 2011b Concept Release on Auditor Independence and Audit Firm Rotation: Notice of Roundtable PCAOB Release No 2011-006 Washington, DC: U S Public Company Accounting Oversight Board, August 11 Peecher M E 1996 The Influence of Auditors’ Justification Processes on their Decisions: A Cognitive Model and Experimental Evidence Journal of Accounting Research 34 (1): 125-140 35   Peecher, M E., and M D Piercey 2008 Judging Audit Quality in Light of Adverse Outcomes: Evidence of Outcome Bias and Reverse Outcome Bias Contemporary Accounting Research 25 (1): 243-272 Peecher, M E., M D Piercey, J S Rich, and R M Tubbs 2010 The Effects of a Supervisor’s Active Intervention in Subordinates’ Judgments, Directional Goals, and Perceived Technical Knowledge Advantage on Audit Team Judgments The Accounting Review 85 (5): 1763-1787 Piercey, M D 2009 Motivated Reasoning and Verbal vs Numerical Probability Assessment: Evidence from an Accounting Context Organizational Behavior and Human Decision Processes 108 (2): 330-341 Plott, C R 1982 Industrial organization theory and experimental economics Journal of Economic Literature 20 (4): 1485-1527 Preacher, K J., and Hayes, A F 2008 Asymptotic and resampling strategies for assessing and comparing indirect effects in multiple mediator models Behavior research methods 40 (3): 879-891 PwC 2011 PwC Comments on Concept Release on Auditor Independence and Audit Firm Rotation Delaware: PricewaterhouseCoopers, December 15 Rice, S C and D P Weber 2012 How effective is internal control reporting under SOX 404? Determinants of the (non-)disclosure of existing material weaknesses Journal of Accounting Research, 50 (3): 811-843 Quadackers, L., T Groot, and A Wright 2014 Auditors’ Professional Skepticism: Neutrality Versus Presumptive Doubt Contemporary Accounting Research (forthcoming) Rottenstreich, Y., and A Tversky 1997 Unpacking, Repacking, and Anchoring: Advances in Support Theory Psychological Review 104 (2): 406-415 Ruiz-Barbadillo, E N Gomez-Aguilar, and N Carrera 2009 Does Mandatory Audit Firm Rotation Enhance Auditor Independence? Evidence from Spain Auditing: A Journal of Practice & Theory 28 (1): 113-135 SEC 2003 Commission Adopts Rules Strengthening Auditor Independence Washington, DC: United States Securities and Exchange Commission press release, January 22 Smith, V L 1982 Microeconomic Systems as an Experimental Science The American Economic Review 72 (5): 923-955 Smith, V L 2003 Constructivist and Ecological Rationality in Economics American Economic Review 93 (3): 465-508 Tversky, A., and D Koehler 1994 Support Theory: A Non-Extensional Representation of Subjective Probability Psychological Review 101: 547-567 Wang, K J., and B M Tuttle 2009 The Impact of Auditor Rotation on Auditor-Client Negotiation Accounting, Organizations and Society 34 (2): 222-243 Windschitl, P D., J P Rose, M T Stalkfleet, and A R Smith 2008 Are people excessive or judicious in their egocentrism? A modeling approach to understanding bias and accuracy in people's optimism Journal of personality and social psychology, 95(2), 253 36   FIGURE Detailed Procedures SESSION INTRODUCTION Participants Receive Hardcopy Instructions, Which Are Read Aloud by an Experimenter Participants Complete a Computerized True/False Quiz about the Instructions Participants Randomly Assigned to Roles as Auditors or Managers Computer Provides RoleSpecific Reminders Regarding Game Play PROCEDURES FOR EACH OF THE 20 ROUNDS Auditor is Paired with One Manager and Round Begins In the Chat Condition Only, Auditor-Manager Pairs Are Allowed to Chat for One Minute Via Electronic Text Manager Chooses Either Aggressive or Conservative Reporting (Aggressive Reporting) Manager Reports this Choice to the Auditor in a Standardized Message that Can be False (Management Representations) Auditor in the Honesty Frame (Dishonesty Frame) Condition then Assesses the Chance that this Message is Honest (Dishonest) This Measures Assessments of Management Representations Auditor Chooses Either Low Effort or High Effort (Audit Effort) Based on the Auditor's and Manager's Choices, the Computer Stochastically Determines Outcomes According to Table Parameters and Provides Feedback Regarding Points Earned In the Rotation Condition Only, Auditor is Paired with a New Manager SESSION CONCLUSION Post-Experimental Questionnaire and Payment 37   FIGURE Effects of Rotationa and Assessment Frameb on Low-Effort Auditsc 75.0% 70.0% 66.2% 65.0% 63.1% Honesty frame 60.0% 55.0% 53.6% 53.0% Dishonesty frame 50.0% 45.0% No Auditor Rotation a b c Auditor Rotation Auditors in the no-rotation (rotation) condition were randomly paired with a manager and remained with that manager for all rounds of the game (were randomly paired with a different manager, at the beginning of each round) After choosing conservative or aggressive reporting, managers send auditors a nonbinding message about their choice Auditors in the honesty assessment frame (dishonesty assessment frame) conditions then assess the chance that this message was honest (dishonest) Low-Effort Audits equals the percentage of rounds in which auditors select low-effort audits 38   FIGURE Effects of Rotation and Assessment Frameb on Low-Effort/Aggressive Reportingc Pairs a 45.0% 40.0% 37.0% 35.0% 33.1% Honesty frame 30.0% 25.0% 25.4% 23.0% Dishonesty frame 20.0% 15.0% No Auditor Rotation a b c Auditor Rotation Auditors in the no-rotation (rotation) condition were randomly paired with a manager and remained with that manager for all rounds of the game (were randomly paired with a different manager, at the beginning of each round) After choosing conservative or aggressive reporting, managers send auditors a nonbinding message about their choice Auditors in the honesty assessment frame (dishonesty assessment frame) conditions then assess the chance that this message was honest (dishonest) Low-Effort/Aggressive equals the percentage of rounds in which auditors choose low-effort audits and managers choose aggressive reporting 39   FIGURE Judgment Process Analysis Assessment of Management Representationsa,b t = 5.45, p < 0.001 Low-Effort Auditsb,e t = 3.42, p < 0.001 (H1b) Rotationc × Assessment Frameb,d t = 2.08, p = 0.040 Low-Effort/Aggressiveb,f Total effect Controlling for mediator(s) 40   a b c d e f The mediator variable Assessment of Management Representations is equal to auditors’ probability assessments of the honesty of management representations in the honesty assessment frame conditions, and 100% minus their probability assessments of the dishonesty of management representations in the dishonesty assessment frame conditions The test of the Rotation × Assessment Frame interaction on Assessment of Management Representations (t = 2.03, p = 0.022) is statistically equivalent to our earlier test that the sum of honesty assessments and dishonesty assessments within the rotation conditions (which is more than 100%) is significantly different (p = 0.022) from the same sum within the no rotation conditions (which is not more than 100%) As a result, the statistically significant indirect path from Rotation × Assessment Frame to Assessment of Management Representations to Low-Effort Audits to Low-Effort/Aggressive (Preacher and Hayes 2008 test = 2.35, p = 0.009) suggests that the judgmental effects predicted by our use of Support Theory are driving the Rotation × Assessment Frame effects for LowEffort Audits (H1a), and, ultimately, Low-Effort/Aggressive outcomes (H1b) Auditors in the no-rotation (rotation) condition were randomly paired with a manager and remained with that manager for all rounds of the game (were randomly paired with a different manager, at the beginning of each round) After choosing conservative or aggressive reporting, managers send auditors a nonbinding message about their choice Auditors in the honesty assessment frame (dishonesty assessment frame) conditions then assess the chance that this message was honest (dishonest) Low-Effort Audits equals the percentage of rounds in which auditors choose low-effort audits Low-Effort/Aggressive equals the percentage of rounds in which auditors choose low-effort audits and managers choose aggressive reporting 41   FIGURE Descriptive Results Over Time of the Effects of Rotation and Assessment Frameb on Low-Effort Auditsc, Low-Effort/Aggressive Reportingd Pairs, and Auditor and Manager Chat Volumee a Panel A: Frequency of Low-Effort Audits (Honesty Frame) Panel B: Frequency Low-Effort Audits (Dishonesty Frame) 0.80 0.80 0.70 0.70 0.60 0.60 0.50 0.50 0.40 0.40 0.30 0.30 10 11 12 13 14 15 16 17 18 19 20 Round Honesty - NoRotation 10 11 12 13 14 15 16 17 18 19 20 Round Honesty - Rotation Dishonesty - NoRotation Dishonesty - Rotation     Panel C: Frequency of Aggressive Reporting (Honesty Frame) Panel D: Frequency of Aggressive Reporting (Dishonesty Frame) 0.80 0.80 0.70 0.70 0.60 0.60 0.50 0.50 0.40 0.40 0.30 0.30 10 11 12 13 14 15 16 17 18 19 20 10 11 12 13 14 15 16 17 18 19 20 Round Round Honesty - NoRotation Dishonesty - NoRotation Honesty - Rotation   Dishonesty - Rotation   42     Panel E: Auditor Chat Volume Panel F: Manager Chat Volume 6.0 6.0 5.0 5.0 4.0 4.0 3.0 3.0 2.0 2.0 1.0 1.0 0.0 0.0 10 11 12 13 14 15 16 17 18 19 20 Round Honesty - No Rotation a b c d e Dishonesty - No Rotation Honesty - Rotation Dishonesty - Rotation 10 11 12 13 14 15 16 17 18 19 20 Round Honesty - No Rotation   Dishonesty - No Rotation Honesty - Rotation Dishonesty - Rotation   Auditors in the no-rotation (rotation) condition were randomly paired with a manager and remained with that manager for all rounds of the game (were randomly paired with a different manager, at the beginning of each round) After choosing conservative or aggressive reporting, managers send auditors a nonbinding message about their choice Auditors in the honesty assessment frame (dishonesty assessment frame) conditions then assess the chance that this message was honest (dishonest) Low-Effort Audits equals the percentage of rounds in which auditors choose low-effort audits Low-Effort/Aggressive equals the percentage of rounds in which auditors choose low-effort audits and managers choose aggressive reporting Auditor Chat Volume equals the mean number of chat messages sent from the auditor to the manager each round Manager Chat Volume equals the mean number of chat messages sent from the manager to the auditor each round 43   TABLE Parameters of the Auditor-Client Relationship: Game Choices, Payoffs, and Probabilities Managers' Financial Reporting Choices: Conservative Aggressive Reporting Reporting Auditors' Audit Quality Choices: Low Effort Managers' payoffs: Misstatement detected [payoff (probability)] Misstatement not detected [payoff (probability)] Expected value Auditors' payoffs: Smaller misstatement [payoff (probability)] Larger misstatement [payoff (probability)] Expected value High Effort Managers' payoffs: Misstatement detected [payoff (probability)] Misstatement not detected [payoff (probability)] Expected value Auditors' payoffs: Smaller misstatement [payoff (probability)] Larger misstatement [payoff (probability)] Expected value (10%) (90%) 5.8 (10%) 10 (90%) 9.1 10 (70%) (30%) 7.3 10 (30%) (70%) 3.7 (90%) (10%) 4.2 (90%) 10 (10%) 1.9 (70%) (30%) 4.6 (30%) (70%) 5.4 We operationalize the auditor-client interaction as a strategic game (e.g., Fellingham and Newman 1985; and Bowlin 2011), where an auditor and manager simultaneously make auditing and financial reporting decisions Specifically, a manager participant is paired with an auditor participant for one (all 20) rounds in the rotation (no rotation) condition The manager picks conservative or aggressive reporting and the auditor picks low or high effort Their joint choice determines two possible probabilistic payoffs for each individual The table lists these payoffs and their probabilities as well as their expected values Each participant’s precise payoff depends on exogenously determined probabilities These probabilities represent (1) the likelihood that more or fewer misstatements occurred and (2) the likelihood that a misstatement has or has not been detected Specifically, if the auditor chooses low effort and the manager chooses conservative reporting, the auditor has a 70% chance of earning 10 points and a 30% chance of earning point, while the manager has a 10% chance of earning points and a 90% chance of earnings points If the players choose low effort and aggressive reporting, the auditor has a 30% (70%) chance of 10 (1) points, while the manager has a 10% (90%) chance of earning (10) points Third, if they choose high effort and conservative reporting, the auditor has a 70% (30%) chance of earning (6) points, while the manager has a 90% (10%) chance of earning (6) points Finally, an outcome of high effort/aggressive reporting yields a 30% (70%) chance of (6) points for the auditor and a 90% (10%) chance of (10) points for the manager 44   TABLE Means (Standard Deviation) by Experimental Condition Panel A: Means by Assessment Frame and Rotation No Rotationl Rotationl Dishonesty Assessment Framem a Low-Effort Audits (Std Dev.) Aggressive Reportingb Assessment of Management Representationsc Low-Effort/Conservatived Low-Effort/Aggressivee High-Effort/Conservativef High-Effort/Aggressiveg Honesty Assessment Framem n=28 53.57% (24.86%) 49.46% (16.01%) 60.84% (16.67%) 28.21% (18.42%) 25.36% (15.39%) 22.32% (14.56%) 24.11% (15.99%) n=30 63.67% (22.85%) 51.33% (21.13%) 69.57% (21.32%) 30.33% (19.82%) 33.33% (22.72%) 18.33% (14.46%) 18.00% (12.84%) Honesty Assessment Dishonesty m Framem Assessment Frame n=25 64.40% (23.73%) 61.40% (16.62%) 58.66% (15.89%) 26.00% (18.03%) 38.40% (17.60%) 12.60% (10.72%) 23.00% (19.36%) n=30 53.00% (24.37%) 48.50% (12.67%) 54.60% (16.13%) 30.00% (17.22%) 23.00% (12.64%) 21.50% (11.53%) 25.50% (16.99%) 45   TABLE (continued) Panel B: Means by Assessment Frame, Rotation, and Chat (Includes Chat Variables) No Rotationl n (Chat | No Chat) Low-Effort Auditsa (Chat | No Chat) Aggressive Reportingb (Chat | No Chat) Assessment of Management Representationsc (Chat | No Chat) Low-Effort/Conservatived (Chat | No Chat) Low-Effort/Aggressivee (Chat | No Chat) High-Effort/Conservativef (Chat | No Chat) High-Effort/Aggressiveg (Chat | No Chat) Auditor Chat Volumeh (Std Dev.) Manager Chat Volumei (Std Dev.) Auditor Persuasion Attemptsj (Std Dev.) Manager Persuasion Attemptsk (Std Dev.) a b c d e f g h i Rotationl Dishonesty Honesty Assessment Assessment Framem Framem n = 14 | 14 n =16 | 14 66.43% | 40.71% 72.19% | 53.92% 52.14% | 48.93% 51.56% | 43.36% 67.34% | 54.33% 79.65% | 58.05% 34.29% | 22.14% 36.56% | 23.21% 32.14% | 18.57% 35.63% | 30.71% 17.86% | 26.79% 15.00% | 22.14% 15.71% | 32.50% 12.81% | 23.93% 2.68 2.58 (2.10) (1.52) 2.46 2.80 (1.64) (1.99) 0.38 0.17 (0.41) (0.21) 0.28 0.25 (0.35) (0.18) Honesty Assessment Dishonesty Framem Assessment Framem n = 10 | 15 n = 15 | 15 75.00% | 57.33% 63.00% | 43.00% 54.50% | 28.00% 59.00% | 44.00% 61.47% | 56.79% 62.19% | 47.01% 40.50% | 16.33% 38.67% | 21.33% 34.50% | 41.00% 24.33% | 21.67% 14.00% | 11.67% 20.33% | 22.67% 11.00% | 31.00% 16.67% | 34.33% 3.84 3.71 (1.55) (0.81) 4.00 4.48 (0.50) (2.12) 0.62 0.43 (0.46) (0.34) 0.69 0.68 (0.56) (0.45) Low-Effort Audits equals the percentage of rounds in which auditors choose low-effort audits Aggressive Reporting equals the percentage of rounds in which managers choose aggressive reporting Assessment of Management Representations equals the auditors' probability assessments of the honesty of management representations in the honesty assessment frame conditions, and 100% minus their probability assessments of the dishonesty of management representations in the dishonesty assessment frame conditions Low-Effort/Conservative equals the percentage of rounds in which auditors choose low-effort audits and managers choose conservative reporting Low-Effort/Aggressive equals the percentage of rounds in which auditors choose low-effort audits and managers choose aggressive reporting High-Effort/Conservative equals the percentage of rounds in which auditors choose high-effort audits and managers choose conservative reporting High-Effort/Aggressive equals the percentage of rounds in which auditors choose high-effort audits and managers choose aggressive reporting Auditor Chat Volume equals the mean number of chat messages sent from the auditor to the manager each round Manager Chat Volume equals the mean number of chat messages sent from the manager to the auditor each round 46   j k l m Auditor Persuasion Attempts equals the mean number of chat messages sent from the manager to the auditor each round in which auditors attempt to persuade auditors to choose low effort Manager Persuasion Attempts equals the mean number of chat messages sent from the manager to the auditor each round in which managers attempt to persuade auditors to choose low effort Auditors in the no-rotation (rotation) condition were randomly paired with a manager and remained with that manager for all rounds of the game (were randomly paired with a different manager, at the beginning of each round) After choosing conservative or aggressive reporting, managers send auditors a nonbinding message about their choice Auditors in the honesty assessment frame (dishonesty assessment frame) conditions then assessed the chance that this message was honest (dishonest) 47   TABLE Effects of Rotation and Assessment Framec on Low-Effort Auditsd b Panel A: ANOVA Source Rotation Assessment Frame Unstructured Chat Rotation × Assessment Frame Rotation × Unstructured Chat Assessment Frame × Unstructured Chat Rotation × Assessment Frame × Unstructured Chat Sum of Squares 0.004 0.009 1.156 0.356 0.007 0.005 0.017 df 1 1 1 F 0.09 0.19 23.98 7.39 0.14 0.09 0.34 p-value 0.761 0.660 < 0.001 0.004 0.706 0.759 0.558 df 1 1 F 2.70 4.80 3.14 4.25 p-value 0.052 0.015 0.040 0.021 a a Panel B: Pairwise Contrasts Source Effect of Assessment Frame under No-Rotation Effect of Assessment Frame under Rotation Effect of Rotation under an Honesty Assessment Frame Effect of Rotation under a Dishonesty Assessment Frame a b c d Sum of Squares 0.130 0.231 0.151 0.205 a a a a These p-values are for effects that occur in the expected direction suggested by our theory (e.g., H1), and are therefore the one-tailed test of the signed t-statistic associated with this F-test (e.g., Kachelmeier and Williamson 2010, Table 2) McNeil, Newman, and Kelley (1996) discuss one-tailed tests of interactions with directional expectations (as in, e.g., Bowlin et al 2009; Kachelmeier and Williamson 2010; Peecher et al 2010) Other reported p-values are two-tailed Auditors in the no-rotation (rotation) condition were randomly paired with a manager and remained with that manager for all rounds of the game (were randomly paired with a different manager, at the beginning of each round) After choosing conservative or aggressive reporting, managers send auditors a nonbinding message about their choice Auditors in the honesty assessment frame (dishonesty assessment frame) conditions then assess the chance that this message was honest (dishonest) Low-Effort Audits equals the percentage of rounds in which auditors choose low-effort audits 48   TABLE Effects of Rotationc and Assessment Framed on Low-Effort/Aggressive Reportinge Pairs Panel A: ANOVA Source Rotation Assessment Frame Unstructured Chat Rotation × Assessment Frame Rotation × Unstructured Chat Assessment Frame × Unstructured Chat Rotation × Assessment Frame × Unstructured Chat Sum of Squares 0.003 0.033 0.037 0.353 0.086 < 0.001 0.055 df 1 1 1 F 0.11 1.11 1.23 11.71 2.86 < 0.01 1.83 p-value 0.737 0.295 0.135 < 0.001 0.094 0.969 0.179 Sum of Squares 0.088 0.290 0.155 0.198 df 1 1 F 2.93 9.62 5.13 6.58 p-value 0.045 0.001 0.013 0.006 a,b a b Panel B: Pairwise Contrasts Source Effect of Assessment Frame under No-Rotation Effect of Assessment Frame under Rotation Effect of Rotation under an Honesty Assessment Frame Effect of Rotation under a Dishonesty Assessment Frame a b c d d a a a a These p-values are for effects that occur in the expected direction suggested by our theory (e.g., H1) and are therefore the one-tailed test of the signed t-statistic associated with F-test (e.g., Kachelmeier and Williamson 2010, Table 2) McNeil et al (1996) discuss one-tailed tests of interactions with directional expectations (as in, e.g., Bowlin et al 2009; Kachelmeier and Williamson 2010; Peecher et al 2010) Other reported p-values are two-tailed While the main effect of Unstructured Chat is significant in Low-Effort Audits (Table 2), its effects are directionally consistent but not significant in Low-Effort/Aggressive (p = 0.135, above) The marginally significant Rotation × Unstructured Chat interaction (p = 0.094, above) indicates that the effect of Unstructured Chat on Low-Effort/Aggressive is significant within the no-rotation conditions (F = 4.09, p = 0.023), but not within the rotation conditions (F = 0.16, p = 0.69) However, this Rotation × Unstructured Chat interaction (p = 0.094) is marginally significant in only this one test, is not robust to alternative model specifications or sensitivity analyses, and is not significant in even this instance after adjustment for the post-hoc nature of the finding (Sidak-corrected p = 0.92; e.g., Piercey 2009) Thus, we find significant evidence of the main effect of chat on Low-Effort Audits predicted by H2, as well as a directionally similar effect of chat on Low-Effort/Aggressive outcomes, but one that is significant within the no-rotation conditions only In contrast, our main finding of the Rotation × Assessment Frame interaction that occurs in the dependent variable Low-Effort Audits (p = 0.022, Table 2) remains a robust effect in Low-Effort/Aggressive as well (F = 11.71, p < 0.001, above) Therefore, of our two main findings for Low-Effort Audits (H1a and H2), H1 is robust to the dependent variable Low-Effort/Aggressive Auditors in the no-rotation (rotation) condition were randomly paired with a manager and remained with that manager for all rounds (were randomly paired with a different manager, at the beginning of each round) After choosing conservative or aggressive reporting, managers send auditors a nonbinding message about their choice Auditors in the honesty assessment frame (dishonesty assessment frame) conditions then assess the chance that this message was honest (dishonest) Low-Effort/Aggressive equals the percentage of rounds where auditors choose low-effort audits and managers choose aggressive reporting 49   .. .The Effects of Auditor Rotation, Professional Skepticism, and Interactions with Managers on Audit Quality ABSTRACT We examine whether the effect of mandatory auditor rotation on audit quality. .. low-effort audits and aggressive reporting Key Words: Auditor Rotation; Professional Skepticism; Audit Quality; Game Theory   I INTRODUCTION We test whether the effects of auditor rotation on audit. .. experimental and archival literature on auditor rotation and skepticism We contribute to the experimental literature on rotation by focusing on unintentional under-auditing and auditors’ assessments of